One of the most popular methods of forecasting financial market prices, useful for making informed investment decisions: this is technical analysis.
Technical analysis is an essential discipline for traders and investors who want to interpret and predict the movements of financial markets. Based on the observation of prices and volumes, this technique is different from fundamental analysis, which studies the economic and financial data of companies.
The main objective is to support traders in making informed purchase or sale decisions. Here’s what it is and how it works.
What is technical analysis? What principles is it based on?
Technical analysis is a tool used to evaluate and predict the future behavior of financial markets through the analysis of historical data, mainly prices and volumes. This approach starts from the assumption that all relevant information is already reflected in prices, thus eliminating the need to analyze fundamentals.
To give a brief definition, we can say that:
technical analysis focuses on the price fluctuations of financial markets and how these fluctuations can be used to predict future movements.
Technical analysis is based on three fundamental principles:
- price discounts everything: all relevant information (economic, political or psychological) is already incorporated into the price;
- prices move in trends: financial assets follow defined trends, which can be analyzed and exploited;
- history repeats itself: traders’ behaviors tend to replicate themselves, making some graphic patterns predictable.
Technical analysis uses charts to identify recurring patterns, support and resistance levels, and other useful signals for making investment decisions. And it is divided into different types, as we will see later.
What is technical analysis for?
Technical analysis has different purposes: we list the most important ones.
- Identify market trends: allows you to understand whether the market is in a bullish, bearish or lateral phase.
- Define entry and exit points: provides clear signals on when to buy or sell an asset.
- Manage risk: helps you set stop-loss and take-profit, limiting losses and maximizing gains.
- Optimize trading strategies: allows you to refine your approach by analyzing the past behavior of the market.
Types of technical analysis
As anticipated, it must also be emphasized that technical analysis is not univocal, since there are various techniques, including chart analysis, trend analysis, moving average analysis and Bollinger band analysis. Let’s explore them together.
1) Chart Analysis
- Chart analysis is one of the most common techniques of technical analysis. It is based on the visual representation of historical prices of an asset, such as a stock or currency, on a chart. Charts can be used to identify trends and patterns, such as long-term bullishness or bearishness, support and resistance levels, and trend reversal figures.
2) Trend Analysis
- Trend analysis focuses on identifying long-term trends in a financial market, such as a stock’s upward or downward trend. This technique is useful for determining the overall direction of the market and identifying entry or exit points in the market.
3) Moving Average Analysis
- Moving average analysis is another common technical analysis technique that uses a mathematical average of historical prices to identify trends and predict future price movements. Moving averages can be used to identify market entry or exit points and to determine the strength of a trend.
4) Bollinger Bands Analysis
- Bollinger Bands analysis is a technique that uses two bands, an upper and a lower band, around a moving average to identify overbought and oversold levels. This technique is useful for identifying trend reversal points and determining the strength of a trend.
How to choose the best tool for you
Technical analysis is a powerful tool for those who want to navigate the financial markets with greater awareness. Learning to read charts, use indicators and recognize patterns is essential to improve your trading performance. However, it is important to remember that no strategy is foolproof: integration with effective risk management is the key to success.
Choosing the “best” technical analysis tools depends on your trading strategy, personal preferences and understanding of various indicators and price patterns.
It is important to experiment with different tools and find the ones that work best for you, always keeping in mind that technical analysis does not always guarantee success in trading and should be used in combination with other forms of analysis (e.g. fundamental and macroeconomic) and with adequate risk management.
You should therefore also evaluate and understand:
- fundamental analysis, which focuses on evaluating the economic and financial performance of a company or economy to determine the intrinsic value of an asset. This technique is very useful in determining whether a stock is undervalued or overvalued;
- macroeconomic analysis, which focuses on interpreting global economic conditions, such as inflation, interest rates, and gross domestic product (GDP), to predict the impact on financial markets. This technique is very useful for identifying investment opportunities at the market and sector level.
In conclusion, technical analysis is a useful tool for trading, but traders must be aware of its limitations and combine it with other forms of analysis to make informed decisions. Before you get into the markets, make sure you develop a solid understanding of analysis techniques and are prepared to adapt to market changes.
Original article published on Money.it Italy. Original title: Cos’è l’analisi tecnica, come funziona e a cosa serve
